Mezzanine Finance White Paper 2Nd Edition
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Mezzanine Finance White Paper 2nd Edition Corry Silbernagel Davis Vaitkunas Amendments to Mezzanine Capital Structures section with Ian Giddy, NYU Stern School of Business, 2012 Copyright © 2003-2018 Bond Capital Mezzanine Inc. - All rights reserved. 1730 - 1111 West Georgia Street Vancouver, BC Canada V6E 4M3 T 604.687.2663 www.bondcapital.ca MEZZANINE FINANCE Mezzanine investments are tailored investments that bring the preferred features of both debt and equity into a single facility. Mezzanine investors are often non-bank institutions and specialty funds seeking absolute return on capital. Mezzanine facilities are customized to the specific cash flow need of the investee Companies that use company, which not only helps the investee company mezzanine capital get more senior debt capital, but may also reduce the access more capital need for equity and thus dilution to the shareholders. and can achieve higher Common transactions that use mezzanine facilities include growth through expansion projects, acquisitions, returns on equity. recapitalizations, management buyouts, and leveraged buyouts. Companies that use mezzanine capital access more capital and can achieve higher returns on equity. The availability of mezzanine capital can be cyclical, while the amount used in any transaction is influenced by market leverage profiles and the availability of senior debt and equity sources. The pricing of a combination of senior debt and mezzanine debt can be comparable to that of a high yield note. Most mezzanine investments are repaid through cash generated by the business, a change-of-control sale or recapitalization of the company. 2 Mezzanine Finance White Paper Copyright © 2003-2018 Bond Capital Mezzanine Inc. - All rights reserved 12 WHAT IS MEZZANINE DEBT? Mezzanine debt capital generally refers to that layer of third party. Although it makes financing between a company’s senior debt and equity. up a smaller portion of a Structurally, it is subordinate in priority of payment and security company’s total available to senior debt, but greater in rank to common stock or equity. capital, mezzanine financing is (Exhibit 1) an important capital source, In a broader sense, mezzanine debt may take the form of filling in the gap between debt convertible debt, junior debt, subordinated debt, private and equity. “mezzanine” securities (debt with warrants or preferred equity), A mezzanine provider will or second lien debt, and is sometimes referred to as quasi- generally seek a risk profile equity. between that of senior debt Mezzanine capital is typically used to fund corporate growth and equity with corresponding opportunities such as an acquisition, new product lines, new pricing. Mezzanine debt can distribution channels, plant expansions, for company owners to often be thought of as take money out of the company for other uses, or to help borrowing equity and senior finance the sale of their business to management or another banks will treat it as such, while the cost of mezzanine debt will be less than equity because of the interest paid and security preference it takes ahead of equity. (Exhibit 2) While capital can be obtained from equity, equity is usually the most expensive and most dilutive source of capital. Shareholder dilution with mezzanine investments is less than with equity investments because much of the mezzanine return is from the loan repayment (interest and principal) rather than from capital gains. Additionally, it is common for a company to repurchase any equity issued to a mezzanine investor and revert back to its pre-financing equity structure. Mezzanine Finance White Paper 3 Copyright © 2003-2018 Bond Capital Mezzanine Inc. - All rights reserved 12 MEZZANINE CAPITAL STRUCTURES While there are no hard and in most mezzanine financing are subordinated notes with fast rules for optimizing a warrants for private companies, and high yield debt (junk company’s capital structure, bonds) or convertible / preferred shares for public companies. companies that use an efficient Mezzanine lenders, typically specialist mezzanine investment combination of senior debt, funds, look for a target rate of return which can be earned mezzanine debt, and equity through two basic components: current payment and deferred capital, seek to minimize their payments. weighted average cost of Mezzanine lenders will also often charge an arrangement capital (WACC) in order to boost fee, payable upfront at the closing of the transaction and shareholder return on equity ongoing administration fees to cover administrative costs and (ROE). as an incentive to complete the transaction. Mezzanine financing can be In structuring a mezzanine investment, the shareholders and completed through a variety of mezzanine investor work together to match the business’ structures based on cash flow, future free cash flow with any repayment obligation. A well- the specific objectives of the structured mezzanine investment will leave excess free cash transaction and the existing available to the company as a margin of safety for asset capital structure in place at the replacement and growth of the business. company. The basic forms used Mezzanine debt is shown to add significant capital, enabling COMPARISON OF PAYMENT STREAMS Current Payments Deferred Payments Paid monthly, quarterly or annually Paid upon maturity of the mezzanine facility or late (Debt Attributes) (Equity Attributes) Cash Interest - a periodic payment of cash based upon a PIK interest - payable in kind interest is a periodic form of percentage of the outstanding balance of the mezzanine payment in which the interest payment is not paid in cash financing. The interest rate can be either fixed or floating. but rather paid in kind by increasing the principal amount through capitalization of the interest payment then due. Principal - scheduled repayments, a portion of which may be deferred until maturity and /or year-end cash sweeps Bonus / Exit Payment – fixed or variable payment that is based on a formula. negotiated. Variable payments are often calculated as a proxy for the business value or change in value of the Royalties – variable payments based on a prescribed company over the duration of the mezzanine facility. formula usually related to revenue, gross margin, EBITDA or net income. Equity Ownership - mezzanine capital will often include an equity stake in the form of attached warrants, a debt for shares conversion feature, or common shares of the company. 4 Mezzanine Finance White Paper Copyright © 2003-2018 Bond Capital Mezzanine Inc. - All rights reserved 3 a company to grow while minimizing the issuance of equity. (Exhibit 3 & 4) On the positive side; the owners face little dilution and maintain control of the business; the company’s total cost of capital is reduced; and the mezzanine debt has a flexible payment term that is structured as “self liquidating” and is paid off over time, or is paid off all at the end (also known as a full bullet payment). On the negative side this is a debt structure that requires some interest payments over time; thus, there is less free cash available for growth and shareholder distributions. The table in Exhibit 5 outlines differences between capital sources. Mezzanine Finance White Paper 5 Copyright © 2003-2018 Bond Capital Mezzanine Inc. - All rights reserved SECURE MORE TOTAL CAPITAL Some closely held companies, particularly those that are family controlled, are reluctant to consider mezzanine financing REASONS FOR THE because it requires relinquishing a certain amount of FUNDING GAP BETWEEN ownership. However, a mezzanine investor’s goal isn’t to be a SENIOR DEBT AND EQUITY 1. Accounts receivable, shareholder, but rather to achieve a target rate of return over a inventories and fixed assets selected period of time. A typical mezzanine transaction has are being discounted at the mezzanine fund as a small equity holder, with buyout terms greater rates than in the past to payout the mezzanine fund and repurchase the equity at the for fear that their values will appropriate time. More importantly, a business owner needs to not be realized in the future. analyze the difference in value between an ownership interest 2. Senior lenders are with the mezzanine investment and without. All else being reluctant to lend, or are equal, an improved valuation represents an improved return on against goodwill or equity for the shareholders. Another way to look at this intangible assets as calculation is: If the mezzanine investment costs less than the collateral. 3. Senior lenders may wish to incremental return on the equity it makes sense, if it costs more limit their exposure to any than the incremental return on equity then it should be one company or industry. considered less favourably. What’s more, having mezzanine 4. Equity may be limited or debt in place can actually help a company secure more total unavailable, prohibitively capital and reduce risk if it helps to properly capitalize the expensive, or highly dilutive. business. Exhibit 6 demonstrates how the addition of mezzanine capital provides more total capital to the business. Banks often look more favourably on companies that are backed by institutional investors such as mezzanine investors and may extend more credit under more attractive terms. This is a result of the mezzanine investors’ risk reducing reputation, and the increased involvement of the mezzanine lender with the company Having mezzanine debt in as compared to with a (senior) bank alone. place can actually help a Simply put, the risk to